From Enterprise Value to Equity Value

1
Chapter 12
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• From Enterprise Value to Equity Value

2
Session Overview

• When you have completed the valuation of core
  operations, you are ready to estimate three
  values enterprise value, equity value, and value
  per share.
• To determine enterprise value, add to the value
  of core operations the value of nonoperating
  assets, such as excess cash and nonconsolidated
  subsidiaries.
• To convert enterprise value to equity value,
  subtract short-term and long-term debt, debt
  equivalents (such as unfunded pension
  liabilities), and hybrid securities (such as
  employee stock options).
• To estimate value per share, divide the resulting
  equity value by the most recent number of
  undiluted shares outstanding.
• Estimating the value per share completes the
  technical aspect of the valuation, yet the entire
  job is not complete. It is time to revisit the
  valuation with a comprehensive look at its
  implications. We examine this process in the next
  session.

3
Enterprise Value and Equity Value

• Enterprise value (i.e., a companys value to all
  financial stakeholders) equals the combined value
  of a companys operations and the value of its
  nonoperating assets.
• A companys value is shared between nonequity
  claims and equity holders. The equity value of a
  company equals enterprise value less the value of
  nonequity claims.

EQUITY VALUE
ENTERPRISE VALUE
PRESENT VALUE OF OPERATIONS Present value of
free cash flows Present value of continuing
value
NONOPERATING ASSETS Excess cash and marketable
securities Illiquid investments and
unconsolidated subsidiaries
NONEQUITY CLAIMS Debt Pensions/leases Employ
ee options Minority interests
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4
The Valuation Buildup An Example

• When measured properly, free cash flow from
  operations should not include any cash flows from
  nonoperating assets.
• Instead, nonoperating assets should be valued
  separately.
• Nonoperating assets can be segmented into two
  groups, marketable securities (marked to market)
  and illiquid investments (held at cost). Given
  their different accounting treatments, each
  nonoperating asset type must be valued separately.

Sample Comprehensive Valuation Buildup
5
The Valuation Buildup An Example

• To calculate the value of common equity, you need
  to deduct the value of all nonequity claims from
  the enterprise value.
• Although nonequity claims include a long array of
  items, they can be grouped into four categories
• Traditional debt
• Debt equivalents such as operating leases,
  pensions, specific types of provisions
• Hybrid claims such as employee stock options and
  convertible bonds
• Minority interests

Sample Comprehensive Valuation Buildup
6
Session Overview

• When you have completed the valuation of core
  operations, you are ready to estimate three
  values enterprise value, equity value, and value
  per share.
• To determine enterprise value, add to the value
  of core operations the value of nonoperating
  assets, such as excess cash and nonconsolidated
  subsidiaries.
• To convert enterprise value to equity value,
  subtract short-term and long-term debt, debt
  equivalents (such as unfunded pension
  liabilities), and hybrid securities (such as
  employee stock options).
• To estimate value per share, divide the resulting
  equity value by the most recent number of
  undiluted shares outstanding.
• Estimating the value per share completes the
  technical aspect of the valuation, yet the entire
  job is not complete. It is time to revisit the
  valuation with a comprehensive look at its
  implications. We examine this process in the next
  session.

7
Common Nonoperating Assets

• Nonoperating assets are assets that do not
  generate free cash flow (or economic profit)
  and, therefore, do not impact the value of
  operations.
• Excess cash and marketable securities. Under
  U.S. generally accepted accounting principles
  (GAAP) and International Financial Reporting
  Standards (IFRS), companies must report such
  assets at their fair market value on the balance
  sheet. Therefore, use the most recent book value
  as a proxy for the current market value.
• Nonconsolidated subsidiaries. Nonconsolidated
  subsidiaries and equity investments are companies
  in which the parent company holds a
  noncontrolling equity stake. Because the parent
  company does not have formal control over these
  subsidiaries, their financials are not
  consolidated, so these investments must be valued
  separately from operations.
• Customer financing arms. Because financial
  subsidiaries differ greatly from manufacturing
  and services businesses, it is critical to
  separate revenues, expenses, and balance sheet
  accounts associated with the subsidiary from core
  operations.

8
Nonconsolidated Subsidiaries Valuation

• The best approach to valuing subsidiaries depends
  on information available
• Publicly Listed Subsidiary
• Use the market value for the companys equity
  stake. Verify that the market price reflects
  intrinsic value (i.e., that there is adequate
  liquidity and free float so that the trading
  price reflects current information).
• Privately Held Subsidiary
• Financial statements are available.
• If financial statements are available, perform
  separate DCF valuation. Use appropriate WACC,
  which may vary from parent companys WACC.
• No separate financial statements are available.
• There are three alternatives to value a
  subsidiary with limited financial information
• 1. Simplified cash flow to equity
• 2. Multiples valuation
• 3. Tracking portfolio

Triangulate results as much as possible given the
lack of precision of these three valuation
approaches.
9
Valuing Publicly Traded Subsidiaries

• As of October 2008, Philips owned stakes in a few
  unconsolidated subsidiaries. One significant
  investment was LG Display, a South Korean
  manufacturer of TFT-LCD panels for use in
  televisions, notebook computers, and other
  applications.

Step 1 To estimate Philipss stake in LG Display,
start with LG Displays market capitalization,
and divide by the exchange rate of South Korean
wons to euros. This converts LG Displays local
market capitalization into euros. Step 2 To
determine the value of Philipss partial
ownership, multiply the resulting market
capitalization in euros by Philipss ownership
stake.
Philips Enterprise Value, October 2008
10
Valuing Privately Held Subsidiaries

• If the parent companys accounts are the only
  sources of financial information for the
  subsidiary, use the following alternatives
• If the parent has a 20 to 50 percent equity
  stake, net income and approximate book equity are
  disclosed in the parents accounts.
• 1. Simplified cash-flow-to-equity valuation
  Build forecasts for how the key value drivers
  will develop and discount at cost of equity for
  subsidiary and not at the parent companys WACC.
• 2. Multiples valuation Build a valuation based
  on the price-to-earnings and/or market-to-book
  multiple. An appropriate multiple can be
  estimated from a group of listed peers.
• For parent equity stakes below 20 percent, the
  only information available may be the
  investments original cost and the date when the
  stake was acquired.
• 3. Tracking portfolio Approximate its current
  market value by adding the relative price
  increase (or subtracting a decrease) for a
  portfolio of comparable stocks over the same
  holding period.

11
Customer Financing Arms

• To make their products more accessible, some
  companies operate customer financing businesses.
• Because financial subsidiaries differ greatly
  from manufacturing and services businesses, it is
  critical to separate revenues, expenses, and
  balance sheet accounts associated with the
  subsidiary from core operations.
• Failing to do so will distort return on invested
  capital, free cash flow, and ultimately your
  perspective on the companys valuation.

12
Customer Financing Arms

• Lets examine FinanceCo. Last year, the company
  sold 1,100 million of machinery at a cost of
  800 million. The company finances a significant
  percentage of its products for its customers,
  generating 300 million per year in lease
  revenue.
• The company currently holds 3,500 million in
  financial receivables. To finance its leasing
  business, FinanceCo raises securitized debt,
  collateralized by the financial receivables. The
  company also has general obligation debt to fund
  everyday operations.

FinanceCo Reorganized Financial Statements
13
Customer Financing Arms

• To analyze FinanceCo, start by constructing
  separate income statements and balance sheets for
  the manufacturing and customer financing
  subsidiaries.
• Using the returns calculated in the following
  exhibit, we can benchmark each of FinanceCos
  subsidiaries against its peers. We cannot,
  however, aggregate the ratios to determine a
  combined return for FinanceCo as a whole.

FinanceCo Reorganized Financial Statements
14
Other Nonoperating Assets

• The preceding items are typically the most
  significant nonoperating assets. However,
  companies can have other forms of nonoperating
  assets as well
• Tax loss carry-forwards Create a separate
  account for the accumulated tax loss
  carry-forwards, and forecast the development of
  this account by adding any future losses and
  subtracting any future taxable profits on a
  year-by-year basis. Discount at the cost of debt.
• Discontinued operations Most recent book value
  is a reasonable approximation since assets and
  liabilities associated with discontinued
  operations are written down to fair value and
  disclosed as a net asset on the balance sheet.
• Excess real estate and other unutilized assets
  Identifying these assets is nearly impossible
  unless they are specifically disclosed in a
  footnote. For excess real estate, use the most
  recent appraisal value, an appraisal multiple
  such as value per square meter, or discounting of
  future cash flows.

15
Session Overview

• When you have completed the valuation of core
  operations, you are ready to estimate three
  values enterprise value, equity value, and value
  per share.
• To determine enterprise value, add to the value
  of core operations the value of nonoperating
  assets, such as excess cash and nonconsolidated
  subsidiaries.
• To convert enterprise value to equity value,
  subtract short-term and long-term debt, debt
  equivalents (such as unfunded pension
  liabilities), and hybrid securities (such as
  employee stock options).
• To estimate value per share, divide the resulting
  equity value by the most recent number of
  undiluted shares outstanding.
• Estimating the value per share completes the
  technical aspect of the valuation, yet the entire
  job is not complete. It is time to revisit the
  valuation with a comprehensive look at its
  implications. We examine this process in the next
  session.

16
Overview of Nonequity Financial Claims

• To find the value of common equity, deduct the
  value of all nonequity financial claims from
  enterprise value. Although there are many forms
  of nonequity claims, these claims fall into four
  primary categories
• Traditional corporate debt such as corporate
  bonds, short-term and long-term bank loans, and
  credit lines.
• Debt equivalents such as operating leases,
  unfunded pension liabilities, specific types of
  provisions, preferred stock, and contingent
  liabilities (e.g., outstanding claims from
  litigation).
• Hybrid financial claims such as employee stock
  options and convertible bonds. Hybrid claims
  have an equity component, but are not controlled
  by holders of common stock.
• Minority interests is the portion of partially
  owned subsidiaries owned by other companies.

17
Valuing Corporate Debt

• Corporate debt comes in many forms commercial
  paper, notes payable, fixed and floating bank
  loans, corporate bonds and capitalized leases.
• Investment-Grade DebtPublicly TradedIf the debt
  is relatively secure and actively traded, use its
  market value.
• Investment Grade DebtPrivately HeldIf the debt
  is not traded, discount the promised payments and
  principal repayment at the yield to maturity to
  estimate current value. Book value is a
  reasonable approximation if interest rates and
  default rates have not significantly changed
  since issuance.
• Highly Levered Companies For distressed
  companies, the value of the debt will be at a
  significant discount to its book value and will
  fluctuate with the value of the enterprise. To
  value equity, create multiple performance
  scenarios and deduct the full value of debt under
  each scenario. Weight each scenario by
  probability of occurrence.

18
Valuing Highly Leveraged Companies

• For distressed companies, apply an
  integrated-scenario approach to value operations
  as well as equity.
• Consider a simple two-scenario example of equity
  valuation for a company with significant debt. In
  scenario A, the companys new owner is able to
  implement improvements in operating margin,
  inventory turns, and so on. In scenario B,
  changes are unsuccessful, and performance remains
  at its current level.

Valuation of Equity Using Scenario Analysis
19
Debt Equivalents Operating Leases

• Because operating leases are a form of secured
  debt, operating leases should be capitalized as
  part of invested capital and as a debt-equivalent
  liability.

Leasing Example Free Cash Flow and Equity
Valuation
If NOPLAT, invested capital, and cost of capital
are adjusted for operating leases, you must
deduct their value from enterprise value to
determine equity value consistently.
20
Debt Equivalents Unfunded Pensions

• Today, under U.S. generally accepted accounting
  principles (GAAP), U.S. companies report the
  market value of pension shortfalls (and excess
  pension assets) on the balance sheet.
• Since only service cost is recognized in free
  cash flow, existing shortfalls must be deducted
  from enterprise value to determine equity value.

DuPont Pension Note in Annual Report, Funded
Status
Present value of unfunded liabilities can be
verified in footnotes.
21
Other Debt Equivalents

• Other common debt equivalents
• For long-term operating provisions and
  nonoperating provisions, the balance sheet value
  offers a reasonable approximation.
• Long-term operating provisions (e.g.,
  plant-decommissioning costs) are typically
  recorded at a discounted value.
• Nonoperating provisions (e.g., restructuring
  charges) are generally recorded at a
  nondiscounted value, but are near term in nature.
  
• Contingent liabilities (e.g., pending litigation)
  should be valued by estimating the associated
  expected (not book) after-tax cash flows and
  discounted at the cost of debt.

22
Hybrid Securities Convertible Debt

• Convertible bonds differ from traditional debt in
  that they give the holder the additional right to
  convert the bonds into common stock.
• If the convertible bonds are actively traded,
  deduct their market value, but only if estimated
  stock price is near the traded stock price, as
  the value of convertible bonds depends on your
  estimate of equity value.
• If the market price differs from your estimate of
  share price,
• Option valuation approach The value of
  convertible bonds can be estimated using an
  adjusted Black-Scholes convertible bond pricing
  model.
• Conversion value approach This common approach
  assumes that all convertible bonds are
  immediately exchanged for equity and ignores the
  time value of the conversion option. The approach
  works well when the conversion option is deep in
  the money.

23
Hybrid Securities Convertible Debt

• Consider Hasbo, which has both traditional debt
  and convertible debt outstanding.
• The Facts Hasbro has 250 million in convertible
  debt that can be converted into 11.56 million
  shares. Based on a share price of 28, among
  other variables, the debt is valued at 326.4
  million.
• The Solution To determine equity value, subtract
  the value of convertible debt (326.4 million)
  from enterprise value. Divide this value by the
  number of nondiluted shares (142.6 million).
• Note how the conversion value method, which
  assumes immediate exercise, mirrors actual share
  price.

Hasbro Convertible Debt, November 2008
24
Employee Stock Options

• Employee stock options give the holder the right,
  but not the obligation, to buy company stock at a
  specified price, known as the exercise price.
• If not specifically expensed as part of NOPLAT,
  outstanding options must be treated as a
  nonequity claim
• Option valuation models The value of options can
  be estimated using option-valuation models such
  as Black-Scholes or advanced binomial (lattice)
  models.
• Under U.S. GAAP and IFRS, the notes to the
  balance sheet report the value of all employee
  stock options outstanding as estimated by
  option-pricing models. This value is a good
  approximation only if your estimate of share
  price is close to the one underlying the option
  values in the footnotes.
• Exercise value approach This common method
  provides only a lower bound for the value of
  employee options. It assumes that all options are
  exercised immediately and thereby ignores the
  time value of options.

25
Employee Stock Options An Example

• Consider Hasbro, whose equity is trading at 28
  per share.
• The Facts The company has 9.73 million options
  outstanding. The options have an exercise price
  of 20.50 and mature in five years. If the
  options are worth 10.13 each, what is the value
  of the company?
• The Solution To determine equity value, subtract
  total option value (134 million) from enterprise
  value. Divide this value by the number of
  nondiluted shares (142.6 million).
• Note how the exercise value method, which assumes
  immediate exercise, overestimates actual share
  price.

Hasbro Employee Options, November 2008
26
Minority Interest

• What is a minority interest?
• When a company controls a subsidiary without
  full ownership, the subsidiarys financial
  position must be fully consolidated in the group
  accounts. The portion of third-party ownership is
  classified as minority interest, and this must be
  deducted as a nonequity claim.
• A minority interest is a claim only on a
  particular nonconsolidated subsidiary its
  valuation is related to the subsidiary, not the
  company as a whole.
• If the subsidiary is publicly listed, deduct the
  proportional market value owned by outsiders from
  enterprise value to determine equity value.
• If the subsidiary is privately held, you can
  perform a separate valuation of the minority
  interest using a DCF approach, multiples, or a
  tracking portfolio, depending on the information
  available.

27
Session Overview

• When you have completed the valuation of core
  operations, you are ready to estimate three
  values enterprise value, equity value, and value
  per share.
• To determine enterprise value, add to the value
  of core operations the value of nonoperating
  assets, such as excess cash and nonconsolidated
  subsidiaries.
• To convert enterprise value to equity value,
  subtract short-term and long-term debt, debt
  equivalents (such as unfunded pension
  liabilities), and hybrid securities (such as
  employee stock options).
• To estimate value per share, divide the resulting
  equity value by the most recent number of
  undiluted shares outstanding.
• Estimating the value per share completes the
  technical aspect of the valuation, yet the entire
  job is not complete. It is time to revisit the
  valuation with a comprehensive look at its
  implications. We examine this process in the next
  session.

28
Calculating Value per Share

• How you determine the value per share depends on
  how options and convertible debt are valued. The
  two methods are
• Option-Based Valuation
• Divide the total equity value by the number of
  undiluted shares outstanding.
• Use undiluted shares outstanding because the
  value of convertible debt and stock options has
  already been deducted from the enterprise value.
• The number of shares outstanding is the gross
  number of shares issued, less the number of
  shares in treasury.
• Conversion and Exercise Value Method
• Divide the total equity value by the diluted
  number of shares.
• Under this method, convertible debt and stock
  options are not incorporated as nonequity claims,
  but rather through the number of shares
  outstanding.
• This method generates a different equity value
  than the option-based valuation.